A Jump Start For Cheap Loans

Thanks to a boom in securitized loans, small companies are getting a good deal on rates

Robert E. Wehe, 81, former successful banker turned hotel entrepreneur, has been around long enough to recognize a good deal. When the businessman received a letter in the mail earlier this year from SierraWest Bank offering great terms to refinance the debt on Wehe's Meadowmont Lodge in Arnold, Calif., he investigated a bit--and then jumped.

The deal: he refinanced $200,000 in debt and got $175,000 in cash to buy an additional hotel. His new monthly payment, however, came out only slightly higher than the one on his old loan. The terms brought down his interest rate from 11% to 8.9%. What's more, he replaced a floating rate with a 20-year fixed rate, letting him escape a pending balloon payment when he refinanced in April. Better yet, Wehe says he can sell the hotel more easily in a few years because the loan is assumable. "I am delighted," says Wehe, who had a 34-year career in banking. Of course, he adds, "I like the fixed rate personally. But if I were a banker, I wouldn't be giving a fixed-rate loan for 20 years."

Has SierraWest gone daft? Did some sort of clerical error give Wehe terms usually reserved for blue-chip companies? Hardly. Wehe can thank the largely unnoticed trend toward securitization of small-business loans. In the past year, a few banks and finance companies have begun to bundle conventional small loans and sell them to investors as securities. This growing secondary market is helping these lenders offer more loans--and larger ones--to small businesses for longer terms and at favorable fixed rates. Spurred by growing competition in the huge small-business loan market and by changes in Small Business Administration (SBA) regulations and federal law, at least a half-dozen lenders nationwide are putting together securitizations primarily for conventional small-business loans. They sold $1.2 billion in securitized bonds in the past 16 months--$1 billion of it in June alone.

It's a trend that is likely to gather steam as the secondary market for securitized small-business loans grows among big institutional investors who buy them. They can only be encouraged by maturities of up to 25 years that often carry AAA ratings, giving a package of small-business loans the same credit standing as IBM or General Electric Co.

In many cases, the benefits are passed on to borrowers. While lenders can offer favorable terms without securitization, some regional banks and financial companies could not offer similar deals without it. "Like the homeowner, the small-business owner can obtain long-term, fixed-rate financing over 25 years. It was unheard-of in the past," says William H. McGaughey, senior vice-president and director of secondary marketing at Bank of the West, which recently purchased SierraWest Bank in Truckee, Calif. "We would not be willing to do these loans without securitization."

The technique isn't new. Securitization has been used to package home mortgages and SBA-guaranteed loans for about 15 years. Under the SBA's general business-loan program, known as 7(a), the government agency guarantees up to 80% of the loan amounts made to small businesses, with private lenders accepting the risk of default for the remainder. In 1985, the lenders began pooling SBA-guaranteed loans and selling them as securities, and in 1992, finance companies were allowed to bundle and sell unguaranteed parts.

Turn of the Tide. Then, in 1994, Congress made securitization of small-business loans easier by relaxing investment restrictions and securities-registration requirements, treating such offerings more as mortgage-backed securities. Still, there was little action during the 1990s, apart from SBA packages and those involving restaurants, auto dealers, and other franchises of big national companies.

Then, about a year ago, the tide turned. Regulations changed, and lenders began to compete intensely for the small-business dollar, expanding conventional loan securitization to a wide range of service and manufacturing businesses. As a result, several regional banks and large financial institutions entered the field (table). The largest deal was a $589 million offering in June by Money Store Inc., now owned by First Union Corp. For the first time, it bundled 850 primarily conventional small-business loans, some of them exceeding the cap of $750,000 to a single borrower that would be required for an sba-backed deal. "The market has become increasingly competitive," says Al R. Bush, senior vice-president for structured products at First Union Corp.'s Capital Markets Group in Charlotte, N.C. Securitization "is a way to keep our customers with loans terms that are more attractive."

Win-Win. That's because lenders are seeing their costs drop, too. First, they don't have to pay guarantee fees to the SBA. Second, reselling the loans immediately means the lenders can improve their liquidity and free up more capital for new loans. And the capital itself is cheap, thanks to the patina of a gold-plated AAA-rating. Lenders have been able to snare capital at an average 7% to 7.5% and then spin off loans at 10% to 11%, according to Jeff J. Orr, vice-president at Duff & Phelps Credit Rating Co. in Chicago. "There is next to no chance investors will lose money on these securities," he says. "It's the magic of securitization."

Still, it's not open season for borrowers. Lenders try to reduce defaults by choosing more seasoned small businesses where cash flow is predictable, diversifying the loan portfolio, or basing the loans on strong collateral. Other protections are built in for buyers of the securitized bonds. But some financial-industry executives question whether lenders have calculated all the risks in small-business financing, which is generally a volatile field. "Time will be the judge as to whether the AAA rating is warranted," says David J. Friedman, a managing director at Chicago's Heller Financial Inc., one of the nation's biggest small-business lenders.

One of the most amazing transformations is AMRESCO Inc., a Dallas financial-services firm that carries a junk-bond rating on its own corporate debt. Nonetheless, AMRESCO has become a big issuer of AAA-rated bonds backed by small-business loans. For example, in June the company completed a $220.9 million securitization transaction, backed by small-business loans to restaurants, convenience stores, truck stops, and funeral homes. About 83% of the offering was rated AAA, backed up by some unusual provisions. Among them: small businesses in AMRESCO's pools contribute 5% to 10% of their loan amount into a contingency fund to cover defaults. In case of trouble, warning notices go out to all other members about a potential deadbeat--giving them a chance to exert peer pressure. "You can kind of rattle his cage a bit," says Rodney Seigler, chief executive of D&S Glass Fabricators Inc., who borrowed $3.2 million through AMRESCO in July to buy the small Dallas manufacturing company.

While some may question the effectiveness of this tactic, some small-business owners think they are getting some great deals. After shopping for financing for three months, Susan E. Frasca got a $1.5 million loan at a fixed rate of 9.5% for nine years without a personal guarantee from AMRESCO to buy four restaurants and create Frasca Hospitality Group LLC in Chicago. "It's pretty much unheard-of," she says. "I know AMRESCO's junk-bond rating isn't great, but it has nothing to do with my bond pool. It's no risk for me."

True enough--she has her money. But lending executives are privately apprehensive that this type of securitization can only work in a hot economy laden with cash-rich investors and prospering small businesses. In a downturn, lenders and investors could get burned. Remember the real estate loans of the 1980s and the mortgage-backed securities derivatives crisis? Sure. But, to paraphrase Frasca, that's not your problem.

Search our database of lenders and investors. Click Online Extras at frontier.businessweek.com

Before it's here, it's on the Bloomberg Terminal. LEARN MORE